Is There A Place For Stable Value In Target Funds?

Target Funds, sometimes referred to as Target Date Funds, are a relatively recent investment innovation. They allow a participant to identify the year fund closest to which they expect to retire and then rely upon the manager of the Target Fund to manage the portfolio strategically aiming toward the beginning of distributions in that target retirement year. For example, if a "20 something" age participant identifies 2045 as the closest year to when they expect to retire, the strategic mix may initially be set at 10% fixed income and the remaining 90% in a diversified spectrum of equities. Each calendar quarter, the manager would rebalance to the strategic mix and each year the strategic mix it self would be adjusted slightly to reflect the somewhat shortened investment horizon. An older participant might identify the year "2020 Fund" as the one closest to their

targeted retirement date. The strategic mix for this fund may start out as perhaps 30% fixed income and 70% equities. But once again the manager would rebalance back to the strategic mix each quarter to maintain the risk profile of the fund and would adjust the strategic mix, by increasing the fixed income component, to reduce the risk profile slightly each year to reflect the shortening investment horizon of this somewhat older participant. Typically the funds are offered with target retirement dates in 5 year increments and then a single fund for use during the retirement payout period. However, recently one of our clients began consideration of expanding the funds available during the payout period from just one with a static strategic mix of 80% fixed income and 20% equities to as many as four payout funds with commitments to fixed income ranging from 51% up to 80%. This change is in recognition of the fact that since people are living longer, the payout periods and investment horizons are quite different for someone age 65 than for someone age 80, even though they are both retired.

At FCM, we think that Target Funds make a lot of sense. The defined contribution industry has spent a great deal of money and effort over the past 20 years trying to educate participants on investing with limited success. Many participants adopt an implicit strategy early on that is often inappropriate to their age and circumstances and then rarely even rebalance back to their strategic mix, let alone adjust the strategy as they grow older. Others are alternately greedy and then fearful and seek to time the market, but end up buying high and selling low, by chasing hot performing funds. "Life-Style Funds" are an attempt to address these problems, but many participants are not sure which fund to select. Some even select multiple funds, negating the value of the life-style funds in the first place. And once they have made a selection of funds, inertia prevents many participants from adjusting their selection as they grow older and closer to retirement. Unfortunately, very few participants adopt an appropriate diversified strategic investment mix, rebalance regularly and then adjust the mix periodically to reflect their shrinking investment horizon over time on their own. But this is exactly what target funds do for a participant.

So what role should stable value play in the spectrum of target funds that your plan may decide to offer? In the table that follows and in the Risk/Return chart on page 4 of this newsletter, it is apparent that FCM's composite of managed stable value portfolios has offered returns that are much higher than those of money market funds with volatility of returns as measured by standard deviation that is significantly less. Even when compared to the Lehman Intermediate Gov/credit index, which at about 3.3 years is somewhat longer than the SV composite, the composite returns have also been higher with dramatically less standard deviation. Of the fixed income indices illustrated, only the Lehman Aggregate index achieved higher returns over the longer time frames than the stable value composite, but this result should be expected since it is a considerably longer index at about 4.4 years. Nonetheless, the Lehman Aggregate's standard deviation was dramatically higher than that of the stable value composite. Moreover, the low correlation of the stable value composite returns with those of stocks is very comparable to both money market funds and the Lehman intermediate and significantly lower than that of the Lehman Aggregate.

A typical spectrum of Target Funds may have the longest dated fund targeted for retirement in 2045, with a strategic mix of perhaps 90% equities and 10% fixed income. Although the Lehman Aggregate demonstrated somewhat higher returns than the SV composite over the longer time frames due to it being a longer duration investment, it also had much higher volatility and higher correlation with equity returns. Therefore, we would advocate committing the full 10% of the fixed income allocation for the 2045 Fund to stable value. In this way the volatility of the common stocks will be moderated more than if a Lehman Aggregate type investment were used, increasing the probability that the participants electing this strategy will not get weak stomachs and abandon it. For much the same reasons, we would suggest that the shorter dated target funds commit the bulk of their fixed income component to stable value, and certainly not any allocation to either money market or Lehman Intermediate funds since stable value has demonstrated higher returns, lower volatility and comparably low correlation with stocks. Once the participant is within about 15 to 20 years to retirement and using the equivalent of the 2020 or 2025 target fund, perhaps a third of the fixed income strategic mix might be allocated to a Lehman Aggregate type vehicle. Doing so would provide some benefit from its somewhat higher return since less return will be achieved from the diminished use of equities. And the portfolio will be less volatile from the reduction in equities, so a little more volatility in the fixed income component is tolerable. In conclusion, Target-Date Funds make sense for participants and using stable value for the bulk of the fixed income component makes even mores sense to enhance portfolio returns and moderate the volatility of equities.